The business news over recent months has done much more than offer sad economic news. Overall, confidence in business people, distrust of the financial establishment, and a new mindset for the terms CEO and CFO are the byproducts that will linger long after the stock market rebounds with normal cycles.

The long aspired-for titles of CEO and CFO have taken on an aura of shady dealing and distrust. As Watergate did to politics, what has been revealed about Enron, WorldCom, Banks, Mortgage Brokers and others yet to surface, will redefine our thinking for some time.

Should we be surprised? Probably not. Since the beginning of time and the first “transaction” between cave dwellers, “creative accounting and compensation systems” have been tools to mask weakness and inflate value. The process and game is not limited to Fortune 1000 enterprises. In reality, it is easier for a one million dollar company to “creatively” position themselves, because the numbers of most small businesses are not audited.

Small businesses normally engage accounting firms to “compile” their numbers. A compilation is merely the correct presentation of the numbers given an accountant. A “review” is a spot check of accuracy and an “audit” is certification of accuracy and consistency. Audits are expensive and most small businesses do not make the investment and merely meet the need for end of year reporting with a compilation.

Knowledge of this is important since the small business is ripe for consolidation. This is due to:

  • The capital investment and scale required for emerging technology.
  • The opportunity for efficiencies with consolidation and overhead reduction.

The above suggests there will be an increase in merger and acquisition activity. If you plan on making mergers and acquisitions, be forewarned: You are entering a field filled with mines and potential expenses.

Let the Buyer Beware

We have not been surprised by the news of accounting irregularities. Over the years, we have encountered scores of “creative” techniques by business people hoping to look better for courtship and even for their banker. This is not new news and will more than likely remain a fact until the end of time.

Here is a sundry list presenting a sampling of techniques and “creative” adjustments to numbers that you should watch for when evaluating a business.

Timing Issues

  • Deferring current expenses to another accounting period.
  • Accelerating discretionary expenses to the current period.
  • Keeping cash-received records open after the end of a period; closing disbursement records early.
  • Depreciating or amortizing at different rates.
  • Writing off future depreciation or amortization in the present accounting period.
  • Liquidating reserves against anticipated returns to shift sales revenue to a later period.
  • Recognizing revenue before it is fully earned or while significant contingencies exist.
  • Delaying publication of financial results.
  • Making unusual entries at or near the end of an accounting period.

Interpretation

  • Not writing off bad loans or worthless assets.
  • Over or under valuing investments, intangibles, and other assets, especially difficult ones like excess inventory, private-placement securities, and contract rights.
  • Ignoring liabilities such as long-term commitments, significant contingencies, or post-retirement liability.
  • Not making adequate provision for depreciation.
  • Overestimating the collectability of accounts receivable.
  • Ignoring the obsolescence of fixed assets.
  • Making bogus estimates, especially on interim financials.

Inventory

  • Misstating inventory by counting empty boxes, altering documents, or adding in inventory that is not salable.
  • Valuing inventory at market price rather than cost.

Sales Numbers

  • Counting revenue before a sale is final.
  • Recording sales to clients who are not likely to pay.
  • Recording phony charges to customers.
  • Continuing to bill clients who have cancelled service.

Combinations

  • Mixing operating and non-operating accounts.
  • Folding a subsidiary’s results into the parent company’s financials.
  • Paying debts out of the owner’s pocket to inflate the price of a company before a sale.
  • Retaining the main asset of the business in the owner’s name.
  • Borrowing through subsidiaries.
  • Failing to separate unusual, non-recurring gain or loss from recurring gain or loss; “restructuring” charges.
  • Using equity or loans to fund dividend payments.

Misrepresentations

  • Using inflation to hide asset revaluation.
  • Reporting quick gains from the sale of undervalued assets or from retiring debt.
  • Burying losses under non-continuing operations.
  • Improperly capitalizing start-up costs, advertising, interest charges, or repairs.
  • Exchanging similar assets and counting what is received at fair market value.
  • Keeping debt off the books.
  • More Bad Stuff
  • Intentionally misapplying accounting methods to actual transactions.

Taking aggressive positions on unsettled, difficult, or controversial accounting issues.

  • Treating refunds as revenue.
  • Entering phony or bogus transactions.
  • Recording income on the exchange of similar assets.
  • Failing to identify related-party transactions.

Lack of Audited/Certified Statements

  • Many business opportunities involve smaller companies where certified statements are simply not available. Consider examining the organization’s books, ledgers, bills, invoices, bank statements, checks, and other supporting documentation thoroughly, with your own eyes